Debt to Equity Ratio
What is Debt to Equity Ratio?
The Debt-to-Equity Ratio (D/E Ratio) is a measure of finance that indicates the relationship between a company's total debt and its total shareholder equity. It reflects the amount of debt a company is employing to fund its business in proportion to the shareholders' investment.
It is an important measure of financial leverage and risk.
Debt to Equity Ratio Formula
Debt-to-Equity Ratio = Total Debt/Shareholders' Equity
- Total Debt incorporates both short-term and long-term borrowings.
- Shareholders' Equity is the remaining interest in company assets after subtracting liabilities (also referred to as net worth).
Example
Suppose a company has:
Total Debt = ₹50 crore
Shareholders' Equity = ₹25 crore
Then,
D/E Ratio= ₹50 crore/₹25 crore = 2.0
It implies that the company has ₹2 of debt for each ₹1 of equity.
Industry Benchmarks
The ideal D/E ratio varies by industry:
| Industry | Typical D/E Ratio Range |
|---|---|
| Tech / Services | 0.2 – 0.5 |
| Manufacturing | 1.0 – 1.5 |
| Infrastructure | 2.0 or more |
Interpretation
D/E < 1: Company is employing more equity compared to debt → Less financial risk.
D/E = 1: Equally financed by debt and equity.
D/E > 1: Firm is employing excess debt over equity → Increased financial risk but potentially greater returns.
Why is it Important?
-
Risk Assessment
Excessive debt can stretch a firm's finances, particularly when profits decline. -
Creditworthiness
Banks utilize it to gauge the firm's repayment capability of loans. -
Investor Insight
Indicates the extent of aggression of the firm in employing borrowed capital. -
Capital Structure Decisions
Assists management in making the correct proportion of debt and equity financing.
Limitations
- Ignores Interest Rates: Does not indicate how costly the debt is.
- Balance Sheet Based: Might not depict current market values.
- Different Accounting Practices: May complicate comparisons.